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Why do CB fix exchange rates - Why no control over MS in Long Run - Effect…
Why do CB fix exchange rates - Why no control over MS in Long Run - Effect on controlling Inflation
Introduction
MS = m (MB)
MB = DC + FR
Fixed Exchange: guarantee DC supply = demand at a fixed rate
Do this by buying/selling FR to ensure Equilibrium
Example:
Saudi Riyal fixed to the USD - Reason is main export is Oil which is traded in USD
Pegging provides a buffer forproducers from Oil price Fluctuations
If USD increases in value due to bullish expectations of US Shares - Need to buy USD to buy stocks - Demand goes up thus price goes up
Saudi CB must now use its FRs to buy Riyal on Int.markets to create a similar demand, increasing Riyal value to that of USD
Refer to MB falling = Ms falls
Implications of Fixed Exchange
To maintain the peg - CB must always be able to buy/sell FR
No control over money supply
No control of MS = no MP in SR under IS/LM
If CB increase MS - LM shifts right - Dom I falls below FIL and UIRP condition is upheld
Pressure on FEX to fall must be relieved by buying DC with FR to maintain peg - reducing money supply back to original - LM shifts back left
Cannot target Inflation as that would require MP
FER can improve Inflation if it is fixed to a major trading partner with lower inflation
Through arbitrage - If CB unable in past to meet inflation targets good option
If Dom Inflation > Trading Partner Inflation, Dom producers become uncompetitive - forced to become competitive or loose market share
Gov introduce structures to improve competitiveness as well to reduce inflation and improve net trade
LIEs and Fixed Exchange Rates
Monetary Policy Requires Three conditions
LIE lack these conditions - Cannot control MS - Trouble controlling Inflation
Competitive Banking Sector
Discount Rate policy requires Both
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Highly concentrated banking sectors who collude to keep interest high
CB decreases DR - however not passed on to consumers in lower loan rates
Due to collusion & Low proportion of population using banking services
Wages tend to be low and Irregular & lack collateral for credit
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Well-Functioning Bond Markets
OMO
makes use of selling Gov bonds
LIE lack functioning bond markets thus OMO cannot function
An Interbank Market
South Sudanese Pound Case
Example:
of Fixed Exchange failing to control Inflation
Forced to float on the 14th December 2015
90% of Revenue came from Oil exports denominated in dollars
FER was to provide a buffer for Dom producers against oil price fluctuations
Fixed at 2.95 SSP per USD
Required alot of FR to maintain - Had $2bn FR
Jan 2012 - Sudan dispute on transit fees led to South Sudan shutting down oil production
Oil Rev fell quickly - main source of revenue - Demand for USD outstripped official rate
Led to emergence of parallel black market
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Conclusion
In the LR - FER prevent CB from controlling Money supply - Must always be willing to alter the MB to maintain the peg